Question

1. The government decreases taxes.

(a) Answer the following questions using the IS-LM model: In the short-run, how does the policy affect the level of national income (Y ) and the real interest rate (r)? Include the appropriate diagram. How does the policy affect the levels of (i) consumption (C), (ii) investment (I), and (iii) government expenditure (G)? How do you know?

(b) Use the long-run model of loanable funds to answer the following questions: In the long-run, how does the policy affect the real interest rate (r)? Include the appropriate diagram. How does the policy affect the levels of (i) national income (Y ), (ii) consumption (C), (iii) investment (I), and (iv) government expenditure (G)? How do you know?

Answer 1

(A) A decrease in taxes wil mean that the IS curve shifts rightwards as this is part of an expansionery fiscal policy. This will cause an increase in real interest rates and national income. However, the increase in real interest rates will cause the level of investment to fall as part of what is called the crowding out effect. Part of the increase in output is thus stemmed due to the fall in investment and the economy is finally at A in the first diagram below. Also as output rises the level of consumption will increase given the marginal propensity to consume but less so because of the crowding out effect. So overall consumption rises but investment falls. Government spending will be uncertain. It cant be said directly from a cut in taxes policy.

(B) A decrease in taxes will mean that disposable income increases. This will cause an increase in the demand for money and the demand for loanable funds rises given by the shift of the curve in the second diagram below. This causes an increase in the interest rates. The level of national income rises as spending potential increases of the people through the rise in disposable income. The level of consumption increases as national income rises given the marginal propensity to consume. As interest rates rise in the long run the levels of investment will fall. The change in government spending will be uncertain however but may rise over time as the level of national income increases.